 | Fed Commits to Low Rates as Far as the Eye Can See |
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| Posted Under: Research Reports |
Yesterday's official statement from the Federal Reserve contained several major changes to its language, including a less optimistic view of the economy and a more dovish outlook on inflation. Most importantly, the Fed dropped the phrase "extended period" when describing how long it intended to keep rates "exceptionally low," replacing it with a commitment to keep rates at such levels until at least mid-2013.
The bar to raising rates before mid-2013 is now very high, as doing so before then – even if economic conditions might warrant – could hurt the ability of some future Fed to credibly commit to such a policy again. In other words, as far as the Fed is concerned right now, short-term interest rate hikes are off the table for this year, all of next year and at least the first half of 2013. This may change if "core" inflation escalates more than the Fed now anticipates, or if real economic growth significantly improves, or a combination of the two. The bar, however, is set high.
On the economy, the Fed said the recovery is "considerably slower" than it had expected, the labor market has deteriorated, consumer spending has "flattened out," and downside risk has grown. Just as important, the Fed said only "some" of the recent weakness can be attributed to temporary factors, such as supply chain disruptions from Japan. Previously its language was vaguer, leaving open the notion that most of the soft patch was due to temporary factors. Also, the Fed said it had downgraded its internal forecast for economic growth for the near future.
Meanwhile, the Fed was more dovish on inflation, noting recent moderation and suggesting that the effects of past increases in commodity prices will "dissipate further."
Near the end of recent statements, the Fed has said it would "monitor the economic outlook and financial developments and will act as needed to best foster maximum employment and price stability." Note the reference to price stability being on par with fostering maximum employment.
Instead, in yesterday's statement, the Fed replaced that language with a paragraph saying it discussed "a range of policy tools available to promote a stronger economic recovery in a context of price stability." This shift suggests more emphasis on economic growth than price stability. Obviously, the tools the Fed discussed are not designed to reduce inflation.
The Fed likely discussed a third round of quantitative easing and ideas like shifting its portfolio toward longer-dated Treasury securities and reducing or eliminating the interest it pays banks on excess reserves. We think the bar to such actions is high at this point in time. Notably, three members of the Federal Open Market Committee (Fisher, Kocherlakota and Plosser), all reserve bank presidents, not members of the Washington DC-based Board of Governors, voted against the commitment to keep short-term rates at near zero through at least mid-2013.
The Fed also used today's statement to say it will keep re-investing principal payments on its portfolio of securities. Given its commitment to keep short-term rates near zero through mid-2013, it's unlikely to start allowing its balance sheet to decline in size until very late 2012 at the earliest.
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